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Sterling and Inflation

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Sterling and Inflation Sterling and inflation An important factor behind the significant reduction in the rate of UK price inflation has been the rise in sterling. By mid-August, however, sterling had depreciated from its peak against the US dollar by over 25% and fram its effective rate peak by over 10%. (1) This note discusses the resulting upward pressure on UK prices. It disputes the view that sterling's movement against the dollar gives a better indication of the inflation effect than the movements in its effective exchange rate. The response of wages is very uncertain. This note suggests that, in the absence of any wage response, consumer prices could rise on account of depreciation by only one quarter of the fall in the effective rate after two years. The relevance of the effective rate Table A Sterling has depreciated heavily against the dollar but by Exchange rate weights comparatively little against currencies in the European Import shares Effective rate index(a) index(a) Monetary System. It has been argued that the United ----- Kingdom has thus had the worst of both worlds: the Austria 0.81 1.00 Belgium 6.85 4.04 maximum inflation effect (because-so the argument Canada 3.73 1.51 Denmark 2.91 1.09 runs-UK import prices, especially of primary products, France 10.29 10.39 West Germany 15.05 14.08 are set in dollars) but with little gain in competitiveness Italy 6.10 7.18 (because the most important markets are in Europe). In Japan 4.52 13.67 Netherlands 8.99 4.80 particular, it has been suggested that the change in the Norway 3.80 2.11 Sweden 3.90 3.73 effective rate understates the impact of recent exchange rate Switzerland 6.90 3.00 changes onUK import prices, and thus on UK inflation, United States 15.95 24.63 Australia 1.28 1.99 because the dollar has a weight of only one quarter in the Finland 2.09 0.85 Ireland 4.71 4.05 sterling effective rate index. Spain 2.12 1.86 (8) Based on share by value in 1980 (overseas trade statistics basis). As presently constructed, the sterling effective exchange rate index is geared to the trade balance effects of exchange rate movements: given a particular set of exchange rate index (see the second column in the table); and in fact the changes against sterling, the index shows that uniform US dollar has a considerably smaller weight in the 'import movement in sterling against all the currencies in the basket shares' index than in the effective index. which would have an equivalent impact on the trade Chart A compares the indices derived using these two sets ) balanceY Though in principle there is no reason why the of weights.The 'import shares' index has recently fallen effective exchange rate should be suitable as an index slightly less fast than the effective rate, so an index measuring the inflationary impact of exchange rate constructed in this way would attach less significance to changes, the weight given to the dollar does not in fact recent exchange rate developments than the effective rate appear to be too low for this purpose. Those who believe index (and, of course, still less than the sterling/dollar rate that the dollar should be given a greater weight than in the alone); this is mainly because of the lower weight given to effective index have made the following points. the dollar in the 'import shares' index. Weights reflectingthe shares of countries in UK imports may Effectiverate weights understate the importance of the be more appropriate for an index directed towards the price dollar, because some UK imports from countries other than effects in this country of exchange rate changes. (3) the United States may also be invoiced in dollars. Table A shows weights based on shares inUK visible The evidence on invoicing ofUK imports is limited. The imports for the countries included in the effective rate results of surveys of currency invoicing ofUK imports 5 index.(4) Except for theUnited States and Japan, the conducted in 1978 and 1979 by the Department ofTrade( ) weights are broadly similar to those of the effective rate suggest that roughly 40% ofUK imports are invoiced in (1) Quarterly averages of these rates are shown in Chart A. Sterling reached its recent peak against the US dollar (12.4650) on 24 October 1980 and in effective terms (105.6) on 28 January 1981. Its construction and the weights used in its calculation were described in the March 1981 Bullelin, page 69. AS Table A (2) . , . shows, the weight of the US dollar in the effective rate index is considerably greater than our lIateral trade with the � .Unlt.ed States would suggest. This largely reflects the importance, for the UK trade balance, of the United States as a competitor In third markets. (3) This assumes that exporters price in/their own currencies without reference to exchange rates. (4) The only sizable omission in terms of import share is Saudi Arabia, though several countries have a larger import share than Austria (the country with the lowest weight in the index). (5) The most recent of these. carried out on imports in October 1979, was reported in British Business, 13 February 198 J, page 318. 365 Bank of England Quarterly Bulletin: September 1981 Chart A weight to the dollar, and that the price implications of the Exchange rate indices(·) recent strength of the dollar are understated by the sterling 197 = 100 Logarithmic scale 5 effective rate index. - 110 Although a full analysis of the interaction between primary product prices and flexible exchange rates is beyond the / scope of this note, an examination of the correlation Sterling I " ! - 100 doU.r I', between aggregate primary product price indices rate \ I denominated in different currencies and the relevant I exchange rates may provide some insight.(I) For this I purpose the dollar and the SDR(2)have been used; if, for - 90 example, a basket of currencies, such as the SDR, is less likely to distort 'true' commodity prices (in other words, if SDR-denominated prices reflect underlying market conditions better than dollar-denominated prices) then movements in the SDR/dollar exchange rate will be more - 80 closely related to movements in the dollar-denominated series than to those expressed in SDRs. The results obtained from relating changes in aggregate primary product price indices (denominated alternatively in 1111111111111111111111111111 dollars and SDRs) to changes in the SDR/dollar exchange 1975 1977 1979 1981 rate are given in Table B. The indices for metal ores and (a) Quarterly averages except 1981 Q3 which is July and August. agricultural raw materials appear to be less sensitive to exchange rate movements when expressed in dollars­ sterling, 30% in dollars and 30% in other currencies. The perhaps reflecting the high proportion of dollar­ share of imports invoiced in dollars is therefore only slightly denominated producer pricing-but this result is reversed greater than the weight of the dollar in the effective rate in favour of the SDR once metals and food are included. index. Furthermore, the currency of invoice is probably only of short-run importance. Over time, prices quoted in TableB dollars will adjust in response to movements in exchange Correlation of monthly percentage changes in the rates: for example, quoted dollar prices may tend to fall SDR/dollar exchange rate and commodity price indices (1976-80) following a general strengthening of the dollar, because third countries will still be able to maintain their previous Denominated in: receipts in terms of their own currencies even if they quote Dollars SDRs lower dollar prices; in addition, demand may weaken if Metal ores -0.185 +0.338(.) dollar prices are not reduced. Thus the invoicing evidence Metals -0.377(0) +0.215 Agricultural non-foods -0.276(0) +0.316(.) does not suggest that changes in the sterling/dollar Foods -0.601(0) +0.025 All items -0.632(0) +0.224 exchange rate should be given any more significance in considering its impact onUK domestic prices than is (a) Significont at the 95% level. already reflected in sterling's effective rate. The results for the foods index are particularly striking, reflecting the importance of products covered by the Primary product prices are particularly important to the Common Agricultural Policy (CAP) of the European United Kingdom, because of their impact on the prices of Community inUK imports. The 'all items' dollar index domestically produced goods. shows a strong tendency to move inversely with changes The importance of theUnited States in the production, in the international value of the dollar, while the consumption and marketing of many internationally traded corresponding SDR index is not significantlycorrelated commodities has made the dollar an obvious numeraire for with the SDR/dollar rate. In addition, the SDR series are a large proportion of trading on commodity markets­ generally more stable: their coefficients of variation are though in so far as it affectsUK import prices this will be smaller than for the dollar indices, even after allowance for reflected in the invoicing data discussed above. But the US trends in the series, and they are not sensitive to exchange dollar prices have also become accepted in some quarters as rate fluctuations. providing a 'true' measure of primary product prices, in the sense that fluctuations in dollar exchange rates are This suggests that the sterling price paid by British industry transmitted-with due allowance for invoicing lags-into for raw materials depends upon sterling's rate against the prices paid in local currencies by other countries.
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